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Authored by Erik Lytikainen via RealInvestmentAdvice.com,

2020 has been quite a year for the stock and options markets. We have witnessed a gut-wrenching roller coaster ride from highs to lows and back to highs. The volumes of both stock and options trading have ballooned as discount brokers offer zero commission trading.

What few seem to realize is that the proliferation of options trading has created a new market dynamic. This dynamic can create feedback loops that could generate significant volatility. If we compare a feedback loop to a snowball rolling downhill, one can view the recent spike in options trading as a snowfall leading to a potential avalanche.

To make our case, we provide a simplified option hedging example to show how this practice can affect order flow in the underlying markets. Specifically, options delta hedging can lead to amplified upward and downward price pressure. With options trading at record volumes, one should not overlook this point.

Options Hedging Example

To illustrate the effects of delta hedging, let’s consider an example. A bank or broker that writes options will usually construct and manage a delta neutral portfolio to manage this risk[1].  For this example, we consider a delta hedger in SPY that ended a recent trading day with a delta-neutral hedged position. We show this in the first table below.

The closing price of SPY is $321/share. The market participant sold 100 call options at the $340/share strike price, with options expiration 28 days away.  To hedge this position close to delta-neutral, the participant sold 57 puts at a strike price of $300/share. There are many ways to hedge the position, and the method we present is common among market makers.

To arrive at 57 puts, the participant calculated how many options are needed to bring the total delta of the position to near zero. As shown below, the call and put delta in the two right columns are essentially equal. However, that will cease to be the case once SPY moves in one direction or the other.

[1] Delta measures how the option price will change as the underlying stock or index changes.

The Next Day

The next day, we assume the value of SPY increases by $4/share to $325/share. The price changes also change the delta values for both the puts and calls. This participant wants to maintain a delta neutral position. To do so, they can buy 8-shares of SPY[1] to neutralize delta (we show the changes to the position in red in the tables below).

The important thing to emphasize is that maintaining a delta neutral hedge requires the participant to buy SPY shares when the price of SPY increases.

To illustrate the same case when the market declines, consider the case where SPY falls by $4/share the next day. In this example, the participant would sell 7-shares of SPY to maintain a delta-neutral portfolio.

Again, the important thing to emphasize is that maintaining a delta neutral position requires the participant to sell SPY shares when the price of SPY decreases.

Therefore, one outcome of delta hedging is that options market makers will buy shares when the market is rising and sell shares when it is falling.

When liquidity is weak and hedging requirements are large, a feedback loop can materialize and amplify price moves. Such occurs when hedge related buying pushes prices higher. As prices rise, hedgers must buy more, which then pushes prices even higher. The same loop can occur on the downside as well.

[1] Since 1-option in the stock markets is for 100 shares, the delta neutral position would require 800 shares of SPY. We are simplifying the calculations for reader understanding.

Risk of Cascading Declines

In the simple example above, we did not consider changes in volatility to adjust our delta hedge. In reality, implied volatilities change rapidly, particularly in a sharply declining market.

When volatility spikes, then the values, deltas, and gammas of options also spike.

Volatility is most likely to rise in falling markets and remain stable to falling in rising markets. The amount of hedging required to hedge downward moves is typically greater than upward moves.

A sharply falling market can result in a cascading feedback loop. Such occurs as delta hedgers must sell increasing numbers of shares to maintain their delta-neutral hedge. Importantly, most of this delta hedging is done by computers, which can further amplify the move as all of the delta hedgers can act simultaneously.

Stock market selling can beget more selling, and in some cases, this can result in a market that looks like a snowball heading downhill.

Gamma Triggers

In studying the options markets, one of our primary goals is to protect your retirement savings from these cascading downward events that can debilitate long term wealth.

To better assess the situation we calculate and share with our subscribers the so-called Gamma Neutral level. This level can be a trigger for follow-on selling and higher volatility in the stock market. As such, it allows us to better understand how options traders are positioned and discover market levels that could trigger a feedback loop.

The chart below shows the historical volatility of the SPX above and below Gamma Neutral levels.

Conclusion

We have provided a simple delta hedging example to emphasize that delta hedging has significant follow-on effects in the stock market. In times of questionable liquidity and record options trading, these implications become magnified. In particular, delta hedging can result in a feedback loop where stock market increases are bought, and systematic delta hedgers sell stock market decreases.

As options trading gains popularity via low or zero-commission trading, the effects of this feedback loop are gaining in importance.

The feedback loop in a market sell-off is proven to be more pronounced as volatility, delta, and gamma all spike. Such results in even larger follow-on selling by machine delta hedgers. The greatest risk of the increase in options trading is the potential for a large, cascading downward move, similar to what we saw earlier this year.

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If you would like to learn more, please visit our website, or download a complimentary report.

Following more rebounds in ‘soft’ manufacturing survey data in Europe and Asia (and LatAm – Brazil Manufacturing PMI exploded to a record in July), both ISM and Markit’s measures of US manufacturing sentiment were expected to continue their v-shaped recovery (despite hard data refuses to follow suit).

However, while the July surveys improved over June, Markit’s PMI notably dropped from the flash print but ISM’s report showed major gains…

• Markit US Manufacturing PMI MISS 50.9 vs 51.3 exp and 49.8 prior (51.3 flash)

• ISM US Manufacturing BEAT 54.2 vs 53.6 exp and 52.6 prior

This is the highest ISM manufacturing print since March 2019

Source: Bloomberg

So take your pick – disappointing intra-month decline (as reopenings are rolled back) or best month in 16 months (because nothing matters)?

ISM New Orders have exploded higher to best since Sept 2018 but employment is not catching up to the “V”…

Source: Bloomberg

On ISM, the company’s spokesperson said:

“The PMI® signaled a continued rebuilding of economic activity in July and reached its highest level of expansion since March 2019, when the index registered 54.6 percent. Four of the big six industry sectors expanded.

The New Orders and Production indexes returned to strong expansion levels. The Supplier Deliveries Index remained at a more normal level of tension between supply and demand. Seven of the 10 subindexes registered expansion, up from five in June,”

But on PMI, Chris Williamson, Chief Business Economist at IHS Markit notes:

“Although indicating the strongest expansion of the manufacturing sector since January, the IHS Markit PMI remains worryingly weak. Much of the recent improvement in output appears to be driven merely by factories restarting work rather than reflecting an upswing in demand.

Growth of new orders remains lacklustre and backlogs of work continue to fall, hinting strongly at the build-up of excess capacity. Many firms and their customers remain cautious in relation to spending in the face of re-imposed lockdowns in some states and worries about further disruptions from the pandemic.

“Encouragingly, business optimism about the year ahead has revived to levels last seen in February, but many see the next few months being a struggle amid the ongoing pandemic, with a more solid-looking recovery not starting in earnest towards the end of the year or even into 2021.

Further infection waves could of course derail the recovery, and many firms also cited the presidential elections as a further potential for any recovery to be dampened by heightened political uncertainty.”

Finally, as a reminder, the euphoric (phew, thank the lord that’s over) rebound has sent ‘soft’ survey data hopes to a level that has historically not portended a good reaction in markets…

Source: Bloomberg

Following the worst month for the dollar in a decade, there has been a bout of position squaring as we start August, largely on the back of a slump in the Euro, which is down 200 pips in 2 days, and accelerating weakness in the Yen, which have sent the Bloomberg dollar index to its highest level in a week, surging the most since June 14.

The spike in the dollar has pushed Treasury yields higher from their all time closing lows printed on Friday (as positive purchasing managers readings in China and Europe helped buoy risk appetite), while the sharp reversal has triggered a furious bout of short covering in Dollar futures, which according to the latest CFTC data has printed the most short in 9 years.

The shorting of the dollar accelerated last week, with Goldman’s FX strategists noting that in the week ending July 28, non-commercial traders net sold $5.2bn USD, following net sales of $2.2bn USD the previous week. Currently, they are net short $24.5bn USD. Both asset managers and leveraged funds contributed to the net sales of Dollars. At the same time, asset managers net sold $6.3bn USD, primarily against net purchases of EUR, JPY, and GBP.

The net sales of USD were primarily against net purchases of $5.1bn EUR, which non-commercial traders have also net purchased in eight of the prior nine weeks. Asset managers are currently net long $48.3bn EUR, the highest exposure in years. Leveraged funds also net sold USD, while net purchasing $1.3bn EUR

A similar increase in net longs was also observed in the Yen.

And now that traders are starting to turn their attention to surging covid cases in Europe and Japan while the US situation appears to have plateaued, expect this rollercoaster to reverse fully with the EUR slide only starting and the Dollar uptrend resuming.

What is most surprising perhaps about the reversal in the dollar is the lack of gold weakness – at least for now – despite the surge in the dollar. Keep an eye on precious metals to see if gold strength continues despite the apparent break in the dollar downside trend.

Just weeks after abandoning a planned move to London – a cancellation that was reportedly politically motivated, according to myriad reports in the British press (more on that here) – ByteDance will reportedly shift its headquarters to London from Beijing.

The decision, which was motivated by the Trump Administration’s threats to bar TikTok from the American market on national security grounds, follows a quiet agreement between British government ministers and ByteDance. Last night, we reported the confirmation that Microsoft had restarted talks with ByteDance regarding a possible acquisition of TikTok.

The company confirmed the reports Monday, and it appears ByteDance has finally shown itself willing to play ball with the US, despite the brief period of uncertainty over the weekend after ByteDance and Microsoft reportedly broke off talks pending more guidance from the administration.

Whoever buys TikTok will control the app and its global operations, but ByteDance will retain ownership of a separate app called Douyin (“TikTok”) which is Chinese-language and built for the Chinese internet.

Microsoft says it’s aiming to wrap up talks by Sept. 15, giving us a 6-week timeline during which we expect the White House to tone down its rhetoric a little bit, even if the administration does move ahead with imposing new restrictions on apps like WeChat, and companies like Huawei.

As investors tried to piece together exactly what was happening behind the scenes, Reuters came through last night with exactly that: a deeply-sourced report citing White House officials who explained that President Trump’s comments on Friday – that the US would move to ban TikTok – elicited serous pushback from his advisors and Republican lawmakers like Lindsey Graham. Trump initially opposed the idea of allowing ByteDance to sell TikTok to Microsoft. But he quickly relented, and by Sunday night, GOP lawmakers had provided enough assurances to BD and Microsoft CEO Satya Nadella that a deal to buy TikTok would receive the administration’s blessing when the time comes for the CFIUS review.

For decades, American law has required a government board to weigh in – and ultimately approve – every foreign deal involving major American assets and ensure that the deal doesn’t impact American national security priorities. China’s wave of ambitious buyouts around the world over the past 10 years – remember, China owns Smithfield foods, one of the biggest pork producers in the world, and a company that’s technically an American company – has made western governments wary of Beijing’s “neo-imperialist” approach.

Once Trump assented to the deal, CFIUS reportedly gave the two companies 45 days to work out a deal (hence the Sept. 15 deadline shared by Microsoft).

Lindsey Graham tweeted over the weekend that a Microsoft buyout of TikTok would be a “win-win” for America and China.

What’s the right answer?

Have an American company like Microsoft take over TikTok.

Win-win.

Keeps competition alive and data out of the hands of the Chinese Communist Party.

— Lindsey Graham (@LindseyGrahamSC) August 1, 2020

TikTok has roughly 100 million users in the US, and has been valued at $50 billion, reportedly. Though it’s unclear what prices MSFT is looking at.

For some reason, we suspect Beijing doesn’t see things Graham’s way. And as Reuters pointed out, whether Microsoft can successfully separate TikTok’s technology from ByteDance in a way that would successfully assuage security concerns remains to be seen. It’s probably one of the biggest risk factors standing in the way of any eventual deal.

A key issue in the negotiations will be separating TikTok’s technology from ByteDance’s infrastructure and access, to alleviate U.S. concerns about the integrity of personal data. ByteDance owns a Chinese short video app called Douyin that was based on the same code used for TikTok.

Not to say that it can’t be overcome. But it certainly explains the intense government scrutiny at every stage in the process, as CFIUS told Reuters it intends to monitor the negotiations.

The negotiations between ByteDance and Microsoft will be overseen by CFIUS, a U.S. government panel that has the right to block any agreement, according to the sources, who requested anonymity ahead of a White House announcement. Microsoft cautioned in its statement that there is no certainty a deal will be reached.

One idea under consideration is to give Microsoft and ByteDance a transition period to develop technology for TikTok that will be completely separate from ByteDance, one of the sources said.

Microsoft said it did not intend to provide further updates until there was a definitive outcome in the negotiations.

The scrutiny facing TikTok isn’t unprecedented: Scrutiny from CFIUS and the White House recently forced a Chinese company to divest its ownership stake in the American LGBTQ-focused hookup app “Grindr”.

But we can’t help but suspect that Trump’s Friday remarks about barring the app from the US have left a bad taste in Beijing’s mouth. We fear the deal talks might be fraught with ongoing conflict as both companies struggle to balance their own priorities with the demands of their respective governments.

As much as we appreciate a good compromise…

Looking ahead to this week now, the release of PMIs from around the world (today and Wednesday mostly) will set the tone, before the July US jobs report on Friday rounds out the week. On the central bank front, we will hear the monetary policy decision from the Bank of England and Governor Bailey’s ensuing press conference on Thursday. The market also enters the second half of Q2 earnings season, which has already seen a record number of beats in the S&P 500.

Looking at the current week, the data highlights will be Friday’s payrolls and various high-frequency economic in the form of survey, with the majority of manufacturing PMIs out on today, before services and composite PMIs come out on Wednesday for the most part. There’ll also be the ISM manufacturing index from the US (today) and non-manufacturing ISM on Wednesday. The key here, according to DB’s Jim Reid, will be to see how differentiated PMIs are given that some governments around the world are cautiously easing restrictions with others needing to tighten. For the countries where we already have a flash PMI reading, they generally showed that the recovery has more momentum in Europe than in the US. Many of the flash European levels were the strongest in at least two years, while both manufacturing and services PMIs in the US failed to meet expectations.

As ever caution is required as these are diffusion indices which simply monitor whether activity is better or worse than the previous month. And as the DB strategist notes, remember that the US was never as shutdown as Europe so momentum was always likely to be more in the latter’s favor regardless of the recent rise in cases.

In terms of payrolls on Friday, markets are generally expecting a third straight month of gains, though likely at a slower rate than we saw in June. DB economists are looking for a further +900k gain in the headline, below consensus estimates at +1.578m. This follows last month’s blowout +4.8m increase. The economists also see the unemployment rate falling to 10.5% from 11.1%, in line with the median estimate. This data will give some insight into how the renewed spread of the coronavirus through the US, especially in the South and West have affected the US economy. The rest of the key data can be found in the day by day week ahead guide at the end.

On the central bank front, one highlight will be the Bank of England meeting and Governor Bailey’s ensuing press conference on Thursday. While most economists do not expect any change to the policy rate this meeting, there is a chance for a dovish surprise on the overall commentary and tone. Focus will be on the central bank’s economic projections, the ongoing review of the effective lower bound, and the path of QE.

Elsewhere in central banks, India and Brazil are also releasing their policy decisions on Wednesday and Thursday, respectively. The two countries have the highest confirmed coronavirus caseloads outside the US, and are expected to lower interest rates in light of the continued economic impact of the pandemic. Following the FOMC last week and the lifting of the blackout period, we will hear from the Fed’s Bullard, Evans, Mester and Kaplan.

Earnings will continue to be in focus, with 133 companies reporting from the S&P 500 and a further 95 from the STOXX 600. Among the releases include HSBC, Heineken, Siemens, Berkshire Hathaway, and Ferrari today. Then tomorrow markets will hear from Bayer, Diageo, Fidelity, BP, Walt Disney and Activision Blizzard. Wednesday will see Deutsche Post, Allianz, Humana, Bayerische Motoren, Regeneron Pharmaceuticals, CVS Health, MetLife and Fiserv release earnings. Following that, Thursday includes Merck, AXA, Siemens, adidas, Bristol-Myers Squibb, Novo Nordisk, Becton Dickinson & Co, Zoetis, T-Mobile, Illumina. Finally on Friday, Standard Life Aberdeen, Norwegian Cruise Line, Royal Caribbean Cruises and Ventas. So another busy week.

Here is a day-by-day calendar of events

Monday

• Data: Japan final Q1 GDP; Japan, China (Caixin), Brazil, Spain, Italy, France, Germany, Euro Area, UK and US (Markit) final July manufacturing PMIs; US July ISM manufacturing index, June construction spending and July total vehicle sales
• Central Banks: Fed’s Bullard and Evans speak on economic outlook
• Earnings: HSBC, Heineken, Siemens Healthineers, Berkshire Hathaway, Global Payments, Ferrari

Tuesday

• Data: Euro Area June PPI; Canada July manufacturing PMI; US June factory orders, and final durable goods orders; Japan CPI, France June budget balance
• Earnings: Bayer, Diageo, Fidelity, BP, Walt Disney, Activision Blizzard

Wednesday

• Data: Japan, China (Caixin), Spain, Italy, France, Germany, Euro Area, UK and US Markit final July services and composite PMIs; US July ISM non-manufacturing index, weekly MBA mortgage applications, June trade balance, and July ADP employment change; UK July new car registrations
• Central Banks: Brazil Monetary policy decision; Fed’s Mester speaks
• Earnings: Deutsche Post, Allianz, Humana, Bayerische Motoren, Regeneron Pharmaceuticals, CVS Health, MetLife, Fiserv

Thursday

• Data: Germany June factory orders and July construction PMI; Italy June industrial production; UK July construction PMI; US July job cuts, weekly initials jobless claims and continuing claims
• Central Banks: Monetary policy decisions from India and the Bank of England; BoE Governor Bailey speaks; Fed’s Kaplan speaks
• Earnings: Merck, AXA, Siemens, adidas, Bristol-Myers Squibb, Novo Nordisk, Becton Dickinson & Co, Zoetis, American Electric, Booking Holdings, T-Mobile, Illumina

Friday

• Data: Japan June labour cash earnings, real cash earnings, household spending, and preliminary June leading index; Germany June trade balance, June current account balance and June industrial production; France preliminary Q2 private sector payrolls, June industrial production, manufacturing production, trade balance and Q2 wages; Spain June industrial output; US July change in nonfarm payrolls, unemployment rate, average weekly hours, average hourly earnings, labour force participation rate, final June wholesale inventories, June consumer credit; China July trade balance, foreign reserves, and Q2 BoP current account balance
• Central Banks: Reserve Bank of Australia statement on monetary policy
• Earnings: Standard Life Aberdeen, Norwegian Cruise Line, Royal Caribbean Cruises, Ventas

Finally as Goldman notes, focusing just on the US, the key economic data releases this week are the ISM manufacturing index on Monday, the ISM non-manufacturing index on Wednesday, and the employment report on Friday. There are several scheduled speaking engagements by Fed officials this week.

Monday, August 3

• 09:45 AM Markit US manufacturing PMI, July final (consensus 51.3, last 51.3)
• 10:00 AM ISM manufacturing index, July (GS 53.6, consensus 53.5, last 52.6); We expect the ISM manufacturing index to increase by 1.0pt to 53.6 in July, after rising by 9.5pt in June. Our manufacturing survey tracker increased from 51.2 to 53.6 in July.
• 10:00 AM Construction spending, June (GS +0.7%, consensus +1.0%, last -2.1%); We estimate a 0.7% increase in construction spending in June, with a faster recovery in non-residential than residential construction.
• 12:30 PM St. Louis Fed President Bullard (FOMC non-voter) speaks; St. Louis Fed President James Bullard will give a speech on monetary policy and the economy at a virtual event. Audience and media Q&A are expected.
• 01:00 PM Richmond Fed President Barkin (FOMC non-voter) speaks: Richmond Fed President Thomas Barkin will give a speech on the economic outlook at a virtual event.
• 02:00 PM Chicago Fed President Evans (FOMC non-voter) speaks: Chicago Fed President Charles Evans will provide a briefing on the economy to reporters on a conference call.

Tuesday, August 4

• 10:00 AM Factory orders, June (GS +6.0%, consensus +5.0%, last +8.0%); Durable goods orders, June final (last +7.3%); Durable goods orders ex-transportation, June final (last +3.3%); Core capital goods orders, June final (last +3.3%); Core capital goods shipments, June final (last +3.4%): We estimate factory orders increased by 6.0% in June following an 8.0% rebound in May. Durable goods orders rose by 7.3% in the June advance report.

Wednesday, August 5

• 08:15 AM ADP employment report, July (GS +1,600k, consensus +1,200k, last +1,000k); We expect a 1,600k gain in ADP payroll employment, reflecting a boost from lower jobless claims and prior-month payrolls.
• 08:30 AM Trade balance, June (GS -$50.0bn, consensus -$50.3bn, last -$54.6bn); We estimate the trade deficit decreased by $4.6bn in June, reflecting a decline in the goods trade deficit.
• 10:00 AM ISM non-manufacturing index, July (GS 54.0, consensus 55.0, last 57.1); Our non-manufacturing survey tracker increased by 49.4pt to 51.2 in July, following stronger regional service sector surveys. However, increased virus-related restrictions in some states are likely weigh on responses. We expect the ISM non-manufacturing index to decrease by 3.1pt to 54.0 in the July report.
• 05:00 PM Cleveland Fed President Mester (FOMC voter) speaks; Cleveland Fed President Loretta Mester will give a speech on the economic outlook at a virtual event. Prepared text and audience Q&A are expected.

Thursday, August 6

• 08:30 AM Initial jobless claims, week ended August 1 (GS 1,300k, consensus 1,415k, last 1,434k); Continuing jobless claims, week ended July 25 (consensus 16,940k, last 17,018k); We estimate initial jobless claims declined but remain elevated at 1,300k in the week ended August 1.
• 10:00 AM Dallas Fed President Kaplan (FOMC voter) speaks; Dallas Fed President Robert Kaplan will discuss the outlook for monetary policy and the economy at a virtual panel hosted by the Official Monetary and Financial Institutions Forum.

Friday, August 7

• 08:30 AM Nonfarm payroll employment, July (GS +1,000k, consensus +1,578k, last +4,800k); Private payroll employment, July (GS +800k, consensus +1,326k, last +4,767k); Average hourly earnings (mom), July (GS -0.3%, consensus -0.5%, last -1.2%); Average hourly earnings (yoy), July (GS +4.4%, consensus +4.2%, last +5.0%); Unemployment rate, July (GS 10.7%, consensus 10.5%, last 11.1%): We estimate nonfarm payroll growth slowed to +1.0mn in July after +4.8mn in June. Our forecast reflects an outright decline in employment in the Sunbelt that is more than offset by net gains in the rest of the country. We also believe education seasonality could boost July payroll growth by as much as 500-750k, as many end-of-school-year layoffs took place in April rather than in June/July. Because of difficulty measuring temporary business closures in the establishment survey, we note scope for nonfarm payrolls to outperform the household survey measure of employment in Friday’s report. We expect that household employment rose by slightly less than payrolls and that the labor force participation rate increased as a recovering labor market encouraged job searches, but that the unemployment rate still fell by four tenths to 10.7% in July. We estimate average hourly earnings declined 0.3% month-over-month (but remain up 4.4% year-over-year) as lower-paid workers were rehired and the composition shift toward higher paid workers continued to unwind.
• 08:30 AM Wholesale inventories, June final (consensus -2.0%, prior -2.0%)

Source: DB, BofA, Goldman

Via Christophe-Barraud.com,

Analysts expect U.S. new vehicle sales to keep rebounding in July after increasing by 42.3% MoM in May and 6.9% in June according to Wards data.

However, June’s level remained quite low at 13.05m (SAAR), far below February’s level of 16.83m, which offers room for another rise in July:

1- According to Cox Automotive, “ the seasonally adjusted annual rate (SAAR) of auto sales in July is expected to be 13.3 million, up from last month’s 13.0 million pace, but down from last year’s 16.9 million level..”

July 2020 should see modest month-over-month improvements in auto sales. But increasing COVID-19 cases and economic uncertainty loom larger than ever. Our July Sales Forecast: https://t.co/Gf7FoW2DGQ #autoretail #automotivenews #automotiveindustry #autosales

— Cox Automotive (@CoxAutomotive) July 29, 2020

2- ALG, Inc., a subsidiary of TrueCar, Inc. projects “total new vehicle sales will reach 1,098,960 units in June 2020, down 24% from a year ago when adjusted for the same number of selling days. This month’s seasonally adjusted annualized rate (SAAR) for total light vehicle sales is an estimated 14 million units.”

3- Industry consultants J.D. Power and LMC Automotive said “The seasonally adjusted annualized rate (SAAR) for total sales is expected to be 14.3 million units, down 2.5 million units from a year ago..”

4- Finally, Wards Intelligences noted “Sales have continually surprised on the upside”. More precisely, they expect sales to reach 14.1 million SAAR.